Custody Rules Boost Third-Party Hedge Fund Aministrators |
Date: Thursday, November 12, 2009
Author: Imogen Rose-Smith, Institutional Investor
In his most recent
client letter, William Ackman, head of New York–based hedge fund firm
Pershing Square, dutifully discussed market conditions. But he also
explained in some detail why the $4.5 billion manager was one of 38
funds participating in Morgan Stanley Fund Services’ beta test of its
new hedge fund custody and administration product, Stratum. That Ackman
felt this development warranted mention is one more sign of how
seriously hedge funds and funds of hedge funds are taking clients’
concerns about custody and transparency in the post-Madoff era.
"For
years due diligence has been all about understanding the investment
process," notes Charles Winkler, COO of $400 million New York hedge
fund firm Hudson Bay Capital Management. These days investors are
asking detailed questions about how the back office works. "This used
to be a trust-me business," Winkler says. "Now it is trust but verify."
And even if clients weren’t insisting on greater openness, the
Securities and Exchange Commission formally is. Embarrassed at not
having uncovered Bernard Madoff’s Ponzi scheme, the SEC has sent out
letters to hedge funds asking them to affirm that they possess the
assets under management that they say they do.
The demand for
heightened operational transparency promises to be a boon for the hedge
fund administration industry. Many large funds in particular have long
preferred to be self-administered, chiefly because they felt that
conventional outside administrators were not capable of dealing with
their complex investment strategies. But then, Madoff also favored
self-administration, if for different reasons.
Not
surprisingly, an almost immediate response to the Madoff scandal was a
push by rattled investors to have hedge funds hire outside
administrators. Many big multistrategy firms, including Caxton
Associates, SAC Capital Advisors and D.E. Shaw Group, have done
precisely that. Caxton hired State Street Global Advisors, and D.E.
Shaw and SAC both signed on with Citco Fund Services.
"The
role of the administrator is changing," points out William Keunen,
director of fund services at Citco. "There is much greater demand, but
administrators need to be able to demonstrate that they are up to the
task and can provide the requisite checks and balances for large,
complex hedge funds."
Nor is Madoff-style fraud investors’
only qualm. When Lehman Brothers Holdings filed for bankruptcy a year
ago, more than $16 billion in hedge fund and other counterparty assets
was trapped in its U.K. subsidiary. Naturally, investors also want to
know a good deal more about where hedge funds are holding their
securities.
Citadel Investment Group’s fund administration
business, which it markets to other hedge fund firms and recently
renamed Omnium (changed from Citadel Solutions, to distance it from the
quantitative hedge fund), scored a major coup in August when it was
appointed to handle Lehman’s assets.
Citco, Omnium and Morgan
Stanley Fund Services are among the firms busily developing new
products catering to the demands for greater openness. In his letter to
clients, Pershing’s Ackman noted that every month there will be an MSFS
Stratum statement independently verifying his fund’s assets and
liabilities, price inputs, counterparty and service-provider
identification, and classifications for SFAS No. 157 (a Financial
Accounting Standards Board rule for valuation measurements).
Morgan Stanley asserts
that it is the first to market with such a complete product. The bank
is now pushing for hedge fund administration guidelines, including a
protocol for verifying asset custody and agreed-on procedures for
valuing esoteric and illiquid assets. "What we are promoting is an
industrywide protocol," explains Seth Weinstein, chief executive of
MSFS.
The firm has made its pitch to both the SEC and European
regulators. Weinstein warns, however, that by adopting third-party
administrators, hedge funds may create a false sense of security among
investors. He points out that the U.S. still lacks universal standards
or laws governing hedge fund administrators, and that the quality of
reporting varies dramatically.
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